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Bold Carney Looks for Stability as UK Economy Recovers

As the Governor of the Bank of England delivers his most significant policy statement since taking office, Mr Bond considers the likely impact of a protracted period of low interest rates.

Despite mixed messages from the City, industry commentators have broadly welcomed the forward guidance contained in the Inflation Report delivered by new Bank of England chief Mark Carney yesterday which links interest rates to unemployment for the foreseeable future.

In what is being viewed as a bold initiative to fuel the current economic recovery with a low interest environment, Mr Carney said that interest rates would not be reviewed until unemployment was reduced to seven per cent – i.e. around 750,000 new jobs had been created, which it estimates will be by 2016.

Greater Certainty

Whilst bad news for savers, Carney said that such guidance was needed ‘so that people… at home, people who are running businesses across the UK can make decisions - whether they are investing or spending - with greater certainty about what is going to happen with interest rates’.

The move comes at a time when it is generally accepted that the economy is gathering momentum, which is precisely when some economists would expect a hike in rates; however the governor said that forward guidance, as delivered by the US Federal Reserve and the European Central Bank was needed now ‘when the recovery is just gathering some steam’.

The Bank of England is thereby mirroring the Fed by confirming that its policy of monetary stimulus would not be scaled back until the economic recovery is well established and sustainable; from the perspective of a fixed-income investor, that will hopefully mean that there will be no repeat of the sell-off in June, which saw £624 million withdrawn from bond funds.

Just to demonstrate the vagary of markets, immediately after the plan was unveiled 10-year gilt yields rose 12 basis points to 2.55% – representing a tightening of monetary conditions and the very opposite market reaction Mr Carney wanted as he seeks to bring down borrowing costs across the economy. Later, however, long gilt yields fell back to 2.485%.

"....Greater interest rate certainty and clarity from the Bank should provide a shot in the arm for business and households - CBI."

The FTSE 100 share index, meanwhile, closed down 1.4 % with traders seemingly underwhelmed by the guidance and concerned about the prospect of a tightening of monetary policy in the US.

John Longworth, director general of the British Chambers of Commerce, said the forward guidance would reassure firms - ‘This will give businesses a much-needed confidence boost when looking to invest, as they know that any plans will not suddenly be derailed by a hike in interest rates.

Business lobby group, the CBI, echoed this sentiment, saying greater interest rate certainty and clarity from the Bank should provide a shot in the arm for business and households. However some commentators believe that unemployment could drop below 7% up to a year before the Bank of England expects, and the possibility of an earlier-than-expected rise in rates lifted the pound on the currency markets, with sterling rising by more than a cent against the dollar to $1.5458.

Fast and Loose

Critics will suggest that Mr Carney is playing fast and loose with the economy, and that printing huge amounts of money to buy government assets at a time of record low interest rates could stoke inflation.

Consequently, the Bank's guidance is subject to three caveats – so called ‘knock-outs’, and breaching any of them would sever the link between interest rates and unemployment levels:

- Consumer Price Inflation (CPI) inflation is judged more likely than not to be at or above 2.5% over an 18-month to two-year horizon

The Bank of England's quarterly inflation report was more upbeat about economic growth than it had been in May predicting accelerating growth for the rest of this year, with its central forecast being for growth of about 2.4% in two years' time.

It also forecast that the CPI measure of inflation was likely to be at its target rate of 2.0% during 2015, although CPI inflation increased to a 14-month high of 2.9% in June, up from 2.7% in May.

With what could be a long period of low, stable interest rates finance directors can plan for their future with more certainty, and retail bonds look set to remain an integral part of the debt profile of many companies. The Bank’s commitment to a programme of QE should ensure that gilt prices remain high and yields low, and with precious little interest to be earned on savings, not only should retail bonds valuations hold up, but as an asset class they are likely to remain attractive to investors seeking value with guaranteed, inflation-beating returns.

Mr Bond would welcome the reaction of investors, lead managers or issuers to Mr Carney’s announcement and thoughts as to whether a policy of forward guidance is to be welcomed in the context of retail bonds.